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Financial Instruments with Characteristics of Equity

Date recorded:

The purpose of this session was to discuss which approach, if any, provides the best starting point for future deliberations. The staff anticipated that during the discussions, the Boards would be able to tentatively reject some of the approaches and focus on the approaches that they believed should be considered for further development. The FASB Preliminary Views Financial Instruments with Characteristics of Equity presented three approaches:

  • Basic ownership approach — in which an instrument would be classified as equity if it (1) is the most subordinated claim and (2) entitles the holder to a share of the entity's net assets. The holders of this class of instruments are viewed as the owners of the entity
  • Ownership-settlement approach — an entity would classify instruments based on the nature of their return and their settlement requirements or that represent (or lack thereof). Instruments that lack settlement requirements or that represent (or upon settlement will present) the most residual claims are classified as equity. The following three types of instruments would be classified as equity:
    • Basic ownership instruments
    • Other perpetual instruments
    • Indirect ownership instruments settled by issuing related basic ownership instruments
  • Reassessed expected outcomes (REO) approach — all basic ownership instruments are classified as equity. Additionally, instruments (and components of instruments) whose fair value changes in the same direction as, or the opposite direction to, the fair value of a basic ownership instrument are classified as equity or contra-equity.

In addition, the staff presented the following five alternative approaches developed by interested parties:

  • Loss absorption approach: Participation in losses is the decisive factor for distinguishing equity from liabilities. Capital is classified as equity if the amount of its claim on the entity's net assets is reduced if the entity incurs a loss.
  • Perpetual approach: An instrument is classified as equity if it (1) lacks a settlement requirement and (2) entitles the holder to a share of the entity's net assets in liquidation.
  • Participation approach: An instrument (or component) is classified as equity if it would participate without an upward limit in the proceeds of a disposal of the reporting entity (or a business within that entity).
  • IAS 32 (without modification): This approach would require the FASB to adopt IAS 32, Financial Instruments: Presentation, without any modifications. Generally, IAS 32 would classify an instrument as equity if (1) It includes no contractual obligation to delivery cash or another financial asset (or to exchange financial assets or financial liabilities under conditions that are potentially unfavorable) or (2) it will be settled by delivering a fixed number of the issuer's own equity instruments or by exchanging a fixed number of the issuer's own equity instruments for a fixed amount of cash or another financial asset).
  • Modified IAS 32: This approach would require the boards to develop a converged standard based on IAS 32. Amendments would be made to the standard to address criticisms identified by constituents.

The staff proposed the elimination of all the above approaches except the Basic Ownership approach and the Perpetual approach. The staff noted that these two approaches would be further developed. The staff may recommend to that the Boards consider incorporating some features of the approaches into the selected approach. The Boards discussed the matter at length, but did not vote on a specific approach. The majority of the Board members supported the elimination of six approaches and the further development of the perpetual approach and the basic ownership approach as a starting point. The Boards agreed to reconvene in November to further discuss the development of a single approach.

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